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Apple Is The Cheapest Growth Stock You Will Ever Own

Here’s the bull case (#longread) on Apple for those whose faith is shaken. It was largely written by Mitch Rubin, a veteran growth fund manager who has held the shares in his RiverPark Large Growth and RiverPark Long/Short Opportunity funds’ top ten for years. Like many of us who have owned it for a while (I own some through my wife’s brokerage account), he’s had a great run but is sitting on a 35% hit from the fall highs. The hyperbole in the media (Forbes is just as guilty) is turned to 11. Time to turn to facts.

For the tl;dr crowd: Apple is the cheapest growth stock you will ever own, and will generate more cash (on top of its current cash) than its entire enterprise value over the next three five years. What growth buyer wouldn’t want a cheap stock? What value buyer doesn’t want a company that materially grows cash? What contrarian investor doesn’t want a stock that’s hated? As Rubin says, “Nirvana.”

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Given Apple has been a top ten holding in the Fund since inception, the stock’s 35% decline from its Fall peak, and that Apple’s stock is also one of the largest decliners in the S&P 500 this year, we thought it timely to review our thoughts on the company.

To answer these questions, Apple’s actual results are more instructive than hyperbolic newspaper headlines. In the company’s most recent quarter (a 13-week quarter vs. last year’s 14-week quarter), revenue grew 18%. The company’s two major products – iPhone and iPad (74% of revenue) grew 28% and 22%, respectively. The more accurate, apples-to-apples, growth results are 27% overall revenue growth, 38% iPhone revenue growth, and 31% iPad revenue growth. These growth rates are the envy of almost every S&P 500 company, especially considering these rates could have been higher since iPhones and iPad minis were supply constrained for the quarter.

Apple’s growth in profits has slowed more significantly and is worthy of a deeper look. In the holiday quarter between 2010 and 2011, the company’s profits almost doubled, and between 2011 and 2012 profits more than doubled. In the holiday quarter just reported, profits were basically flat (on an apples-to-apples time period, operating profits increased 7%, still a far cry from the previous two years). While Apple’s operating profits are still strong — $17 billion and a 32% operating margin – the market wants to believe this will grow, not shrink.

The company’s profitability decline can be attributed to a few factors: (1) the new iPad mini, which sells for significantly less than the full-size iPad; (2) lower short-term margins due to the ramp over the past quarter of new products across 80% of Apple’s product line; and (3) unusually high margins a year ago. For context, Apple’s gross margins were approximately 40% 2009-2011, then 44% last year, the result of lower commodity costs and fewer new product introductions. With the manufacturing ramp of the iPad mini and the iPhone 5 this past quarter, gross margins fell to 39% and the company is guiding margins to 38% next quarter. This return to normalized gross margins, or even shy of past gross margins, isn’t a reason to panic about Apple’s future. Apple’s gross margins have historically rebounded from lower-margin quarters post new product manufacturing ramps (the iPad introduction temporarily lowered gross margins to 37% from 39%). The iPad mini is competing with devices that don’t make any money.

Apple is still making money, albeit less, as a percentage than it did in the recent past, but at 38% gross margin (compared with 20%-25% gross margins for Samsung, Dell and HP), we are impressed, not worried, especially when you consider Apple’s opportunity in tablets could be larger than the worldwide market for PCs (as many expect).

Apple has a couple structural advantages that distinguish the company from declining businesses of PC hardware makers and commodity cellphone manufacturers, and should help it to maintain its margins. Apple is a vertically integrated company – they design their own microprocessors (the A6 chip), have their own operating system (iOS), design their own hardware, and retail the vast percentage of their products in their own stores that also provide hands on customer service and support. Apple also generates billions of dollars in ecommerce and software revenue through iTunes, the App Store, AppleCare, iBookstore, and Apple.com. This e-commerce and software revenue ($13 billion in FY12, up 38% year-over-year) is not only high-margin, but, more importantly to us, these products combined with the company’s retail customer service experience provide an ecosystem with incredibly high switching costs to change phones, tablets, or computer brands. To put this in perspective, during the PC era (which lasted for 20 years) this would have been the equivalent of combining Intel, Microsoft, Dell and Best Buy into one firm, selling one brand.

Instead, you could go to any computer retailer to buy any type of computer with Intel and Microsoft inside. In today’s wireless era, Apple is the equivalent of combining Qualcomm, Google’s Android operating system and apps, Samsung’s hardware, and Amazon’s retail into one firm. Because of Apple’s vertical integration, ecosystem and resultant switching costs, we believe the company can sustain operating margins at or about its just reported 32%.

Few would argue Apple shares are not cheap relative to the market. At its current $460, Apple’s stock trades at just 3x its $137 billion of cash, 9x our FY2013 EPS estimate (6x excluding its cash), 5x our FY2013 EBITDA estimate, and has a 12% free cash flow yield. These metrics are more than a 30% discount to the S&P 500s’s 14x P/E and 9x EBITDA. Meanwhile, Apple pays a 2.3% dividend yield vs. the S&P 500’s 2.1%.

Given the company’s cash-generation profile, even fewer realize how truly cheap Apple shares are. For perspective, Apple’s $460 share price also gets you $145 per share of cash, so you are really paying $315 per share. We expect the company to generate $55 per share of cash this year, reducing your purchase price to $260. Modeling what we believe to be very conservative five year EPS growth of 13% (compared with the past five years of 62% growth) — we would expect Apple to generate an additional $290 per share of cash returning all of your money, plus an additional $30 by 2017. Not a single company in our portfolio generates as much cash as fast as Apple, returning its entire market value in cash in five years.

We are acutely aware that a stock price only seems cheap when a company’s business is declining. However, while Apple’s growth will certainly slow from its past torrid growth rates, causing future cash growth to slow as well (our 13% growth modeling should more than account for that), it is important to recall that last quarter consumers bought almost 6 million iPhones, iPads, and Macs per week, driving pro-forma 27% revenue growth.

Yes, while the stock is cheap and recent growth, although a deceleration, has still been strong, it is the future that matters. For Apple, that means future products. Last year the company spent a combined $12 billion on research and development and capital expenditures. Notably, our 13% EPS growth forecast is based only on current products and enhancements, yet included in our projections is $70 billion of estimated research and development and capital expenditures over the coming five years. Much of this spend should generate new products and investment returns neither of which are incorporated in our projections. For context, in early 2010, Wall Street did not incorporate iPads in their models. Two years later, iPads generated more than $30 billion in revenue.

Reprinted with permission of RiverPark Advisors, an investment shop in NY that runs equity and fixed income portfolios.

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How does correcting for 14 vs. 13 week quarters mean you get to increase growth rates by 50%, from 18% to 27%?

How can you forecast 13% EPS growth in the future on top of record high earnings, in the face of increased competition and lower margins, when the last quarter showed no such growth following launch of a new product?

How can you claim Apple is more vertically integrated than Samsung?

Apple may well mint cash, but so did Microsoft. How did those shares do?

I don’t think Google Ads is really the point. The article is full of misleading claims, of which I called out only a few. For example, what does “retails the vast percentage of their products in their own stores” mean to you?

“Apple sold just 21 percent of iPhones purchased between December 2011 and August 2012, according to a study by Consumer Intelligence Research Partners (CIRP). Indeed, AT&T outlets sold 28 percent and Verizon sold 26 percent of iPhones.”

None of these companies controls their own destiny. Apple depends on a variety of component manufacturers to make essentially everything that goes into its products, which is not the case in a truly vertically integrated manufacturer.

Hi Doug, 13% earnings growth through fiscal 2016 is the consensus right now among all the analysts. It’s not just this guy’s forecast. Apple is WAY more vertically integrated than Samsung when you look at the whole value chain: when was the last time you downloaded a movie from samsung or shopped in a Samsung store? And Microsoft has missed every major hardware transition in the last ten years, that may help explain why it’s shares did what they did (not do).

You get it…only emphasis I would have included is the ‘software ecosystem’, which is unprecedented – (iCloud – Synced Email/Contacts/Apps/Calendar/Reminders/Notes on all iDevices Realtime, Desktop Mac OS integration, iTunes Match, iMessage, Siri, Notification Center, Game Center).

AAPL’s valuations are ‘once-in-a-generation’ at this point. Will continue to dollar-cost avg. into AAPL as low as it wants to go (Funds from my other S&P stocks that are soaring create an optimal re-balancing opportunity)

Wow, talk about an ethical lapse. This guy has a vested interest in seeing Apple stock go up so he’s encouraging people to buy. The lapse, though, is Forbes printing it as “advice.”

Did you sleep through the ethical writing sections of your communications courses?

Because putting the disclaimer up doesn’t make it ethical. It just makes you look stupid. You also forgot to include the disclaimer that’s on the original site:

“The opinions and material presented in articles are an assessment of the market environment at a specific time and are not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.”